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The second game in the series and covers chapters three to five of an originally proposed sixteen. The game takes place in three major locations; Hong Kong island, Kowloon (an exclave of Hong Kong that resides in mainland China) and Guilin, China. The game was originally released on Dreamcast over 4 discs, and years after an Xbox port of the game was released. The Dreamcast version was originally going to be released in the US as well but was cancelled in favour of the Xbox port.

The most obvious difference between the Dreamcast and Xbox versions is the audio. The European release of Shenmue II had Japanese audio with subtitles, whereas the Xbox version has a full English dub. Besides this, the game is exactly the same as the Dreamcast version with only a few minor extras. The first being in the addition of a camera in which you can take photos during the game. Taking pictures of certain characters unlocks extra bonus comics and artwork. There was also the option of viewing the game in a different colour palette, such as sepia. Additionally, the Xbox version has the entire game on one disc, plus the Shenmue The Movie disc was also included as an extra disc. The game has also been made back-wards compatible and can be played on an Xbox 360.

Sometime in late February 1987, Ryo arrives in Aberdeen, Hong Kong and begins his search for Master Lishao Tao whom Master Chen has given him the address of as someone who can be trusted. Ryo eventually finds Lishao Tao in Wan Chai and much to his surprise she is a young looking female master of a Taoist temple. Along the way Ryo also runs into several new people such as Joy, a strong minded girl who often rides a motorcycle, the local martial artists such as Jianmin, Guixiang and Zhangyu and also a brief run in with a gang who stole his bag and money. After explaining his situation to Lishao Tao, real name Xiuying Hong, and how he wishes to meet with Yuandha Zhu, however Xiuying refuses his request as she believes Ryo's martial arts skills are nowhere near enough to contend with LanDi, and that he may also fall onto the wrong path. She does not explain her reasons though, but allows Ryo to stay with her and gives him tasks at the Temple. Ryo also meets a young girl who works at the Temple called Fangmei who seems to take a liking to him. Despite Xiuying's reluctance to assist Ryo with finding Yuanda Zhu, Ryo takes it upon himself to investigate in the local area to see if he can find out anything. He soon learns that Yuanda Zhu was the author of a book called the Wulinshu and that a copy of the book is kept in the Man Mo Temple Library. Xiuying eventually allows Ryo to see the book and inside he finds a piece of paper with a Chawan Sign drawn on it, which he learns he can use to contact those who know Yuanda Zhu. Ryo performs the Chawan Sign and comes into contact with Zhang, someone who works under Yuanda Zhu, but he tells Ryo that even he does not know of Yuanda Zhu's current whereabouts as he has hidden himself from the Chi You Men. However, he does give Ryo the name of someone who might be able to help him, Ren of Heavens, but warns Ryo that he is very dangerous and the leader of a gang in Aberdeen.

Despite the risk, Ryo heads to Aberdeen and eventually is able to find some information on the gang and arranges a meeting with Ren at the cost of a large amount of money. After taking Ryo's money, Ren tries to kill him but Ryo's persistence eventually pays off when Ren agrees to help Ryo find Yuanda Zhu in exchange for some of the money he swears must be involved. Ren and Ryo both head to Kowloon on mainland China where Ren says Yuanda Zhu is.

Upon their arrival, Ren explains he doesn't know where in Kowloon Yuanda Zhu is, so they go to see Yang who used to work for Yuanda Zhu. Yang agrees to set up a meeting for them with Yuanda Zhu but it was a trap leading them straight to Dou Niu, a leader of a large, notorious gang that operates in Kowloon called the Yellow Heads. They are also a rival gang to Ren's Heavens gang, so Dou Niu overpowers them both and has them locked up. After 3 days, Ren and Ryo finally escape and head back to Ren's Hideout on the outskirts of the main city with Wong and Joy joining up with them from Aberdeen. They go back to the main city again to search for any clues for Yuanda Zhu's whereabouts and soon learn that Zhang, the informant Ryo met in Wan Chai, is being held by Yuan, a high ranking member of the Yellow Head. Ren and Ryo rescue Zhang and learn from him that Yuanda Zhu is hiding at the top of the Ghost Hall Building. The two of them head over there but before they can ask Yuanda Zhu anything, Dou Niu and some other members of the Yellow Heads arrive, having followed them and kidnap Yuanda Zhu. Ren makes a run for it and Ryo is left to deal with Dou Niu, he greatly overpowers Ryo forcing Xiuying to intervene. It seems she had also followed Ryo to Kowloon..

Three days later Ryo awakens, determined to rescue Yuanda Zhu from the Yellow Head comes up with a plan with the help of a man named Kai who plays the violin on Dragon Street, who was also a friend of Iwao when he visited China decades ago. Kai tells Ryo that the Yellow Head scout new members by watching participants of street fights, if Ryo wins enough fights he will get noticed. Ryo does exactly that and soon gets noticed by the Scout, getting invited to a secret underground entrance to the Yellow Head Building. Ren follows Ryo there and knocks out the scout so that the two of them can barge their way into the building. It's heavily guarded and they soon learn that Yuanda Zhu is on the 40th floor. Ren and Ryo are forced to split up, and Ryo discovers that Joy is being held hostage, and only able to free her by defeating a street fighter named Baihu. Ryo succeeds and he and Joy head to the 40th floor, Joy also tells him that Wong has been taken to the roof. They make it to the roof and find Yuanda Zhu there with Dou Niu and Wong, Ren isn't too far behind. A helicopter flies overhead with LanDi hanging from a ladder, ready to pick up Yuanda Zhu, but before he can Ryo is forced to deal with Dou Niu. It's a tough battle, but Ryo is able to defeat Dou Niu, causing LanDi to leave without Yuanda Zhu, the group head back to Ren's hideout.

In the safety of the hideout, Ryo explains what happened between his father and LanDi to Yuanda Zhu and shows him the Phoenix Mirror. Yuanda Zhu goes on to explain that LanDi is infact SunMing Zhao's son, Longsun Zhao, and killed Iwao because he believed Iwao killed his father. Yuanda Zhu says that he doesn't know if this was true, but he does know that Zhao died, and that the two mirrors belonged to Zhao. When the mirrors are joined together they form a key of some kind, although he does not know what it is exactly they lead to. He finishes by saying that LanDi has gone to Bailu Village in Guilin where the mirrors originally came from, so Ryo decides he will head there next, alone as Ren refuses to follow him any further despite his interest in the treasures. Ryo leaves once again, heading briefly back to Wan Chai where he meets Xiuying again. Before he leaves, Xiuying gives Ryo half of a stone in the shape of a Yin Yang.

Ryo arrives in Langhuishan, Guilin, and begins the 2 day trek across mountains and through forests to reach Bailu Village. On the way he runs across a girl named Shenhua who happens to live in Bailu Village so she shows Ryo the way, letting him stay at her and her step-fathers house for the night. Ryo explains to Shenhua about some of the reasons why he has come to Guilin and whilst staying at Shenhua's house he finds a blueprint of the Phoenix and Dragon mirror which Shenhua says her step-father had told her was in his family for generations. The next day they both go to the Stone Pit where Shenhua's step-father has been but find him to be missing, only leaving behind a cryptic letter and a sword with seven stars on it. They delve deeper into the pit and find a mechanism that, once the sword and Phoenix Mirror are placed into, reveals two large carvings into the wall of the Phoenix and Dragon Mirror...